COLLATERALIZED DEBT OBLIGATIONS

Collateralized Debt Obligations, or CDOs for short can be created from many types of collateral, but the most popular lately are CDOs from MBS (Mortgage Backed Securities). The idea is to create some higher risk assets and some much safer ones, slicing up the MBS into what are called equity, mezzanine and investment-grade bonds. The equity takes the higher risk, and so it earns the higher return if things go well. But if things start to go wrong, the equity is lost first…and then the mezzanine. However, even if there’s quite a high rate of failure in the higher risk end, the investment-grade bonds still get fully paid out. In this way the bankers might, for example, convert a large package of MBS into perhaps 70% investment grade bonds, 15% mezzanine, and 15% equity. It is relatively easy to sell the high-grade investment bonds. Stamped with an investment-grade rating, these bonds are sold off to mostly respectable investment institutions. But the mezzanine, and particularly the equity, are harder to sell. In effect the 30% of the mortgages in the original MBS which were deemed on a statistical basis to be likely to fail, are concentrated into what investment insiders call “Toxic Waste”.  Enter the case of the Bear Stearns hedge funds:

Last week, increasing losses and redemptions induced the lenders of two highly leveraged (at least 10 to 1) hedge funds in “structured” instruments (Toxic Waste) to hit The Street with bid lists of CDO collateral loaded with subprime exposure.  The dearth of buyers willing to pay anything close to their “marked” prices forced the sponsor, Bear Stearns to step up and loan the hedge funds $3.2 billion. However, the specter of downgrades of similar securities and a possible contagion de-leveraging of CDO exposures throughout the market initiated a stock market plunges that is continuing today.

On the other hand, we keep telling you that 10-year US Treasuries is the only investment we believe in, no matter how much of them the Chinese may be selling. Last Friday, for the first time since the 10-year treasury yield started rising from a low of 4.602% on May 11th to a high of 5.316% on June 15th, it rose as equities dropped. This is quite significant in that it confirms a new top from which 10-year treasury yields will probably drop as they have over the past 20 years. You can check this behavior in Chart1 below. Notice that the RSI Readings over 70 (se dotted line) have marked peaks in interest rates and the current reading near 90 hints at either a pause or a pullback in rates.

CHART 1. Source: StockCharts.com
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In the meantime, the slowdown in retail sales is quite visible after peaking in early 2006, and has turned south sharply following the bursting of the housing bubble. This trend will likely continue heading if retail sales follow its historical relation to the yield curve as it has in the past, as the yield curve leads the trend in retail sales by roughly two years (advanced in chart 2 below).

CHART 2. Source: Moody’s Economy.comimage002

With such a negative housing backdrop, it’s understandable why retail sales are falling and consumers are putting off their plans to purchase big ticket items. Business equipment industrial production has clearly peaked on a year-over-year (YOY) basis and lags the shape of the yield curve by one year, indicating continued weakness for the rest of 2007.

CHART 3. Source: Moody’s Economy.com
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Finally, if you are going to keep some Treasury securities in your portfolio, you can either buy them from us or consider buying them yourself. It is quite easy to buy Treasury securities with a broker. Just go to the Treasury Direct web site (www.treasurydirect.gov) and follow directions. The purchases are paid for by direct debit to your current bank account.

BLOOMBERG TELEVISION

Tuesday, when markets were down huge, Bloomberg Television inquired what we thought of the PDVSA bond plunge of the past few weeks. We pointed out that PDVSA bonds had done nothing but follow the rest of Venezuela’s external debt bonds down in price. If you look at the first graph below, you will notice that since late march, when PDVSA bonds were issued, until yesterday, Global 34´s, for instance, plunged 15% compared to PDVSA 37´s which dropped a bit less. We told Bloomberg TV there were two reasons why PDVSA bonds performed a bit better. First, from issuance these bonds were arbitraged against Global 18s, 27s and 34s on the basis of “better yield, same debtor and similar period”. Secondly, we believe the bonds have performed better because Venezuelan institutions and individuals (who are still a majority of the holders) are historically prone to hold paper losses instead of realizing them. WHAT NEXT ON PDVSA As we mentioned last Thursday, there was a great chance we would see an overall market rebound. However, the fact that your PDVSA bonds were helped by the rally doesn’t mean you are of out the woods, but we expect that good core PPI figures today and possibly good core CPI numbers tomorrow could inject additional energy to the rebound and hopefully get your bonds higher. Just don’t wait too long after that to start exiting your positions. WHAT WITH TREASURIES China may be the reason behind the swoon in Treasuries of the past two weeks. As you can confirm in the chart below, at least $12.5 billion in 10-year Treasury notes were dumped by “Fgn Official & Intl Accts” during the first week of the plunge. I am sure this week an even larger figure will be reported. In our view, these sellers are Chinese because “they have got motive”. Increasing US rates revalue the dollar, devalue the Yuan and keep the Chinese BoP growing, especially now that China’s yuan rose to a record high against the U.S. dollar after U.S. lawmakers brought up pressure on Beijing to adjust its foreign-exchange policy. Our conclusion: let’s keep checking the weekly updates of the second chart below over the next few weeks. In the meantime, we have been buyers of 10-yr Treasuries this week. As you know, we think Fed rates this year are ultimately going down, not up.

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US stocks

We are probable witnessing the last stage of a major bull market in US stocks. However, knowing if this stage will take a few weeks or a few months is what matters and that information is not yet evident to us. On the other hand, there has been a pickup in economic indicators that sent the 10-year Treasury note’s yield on Friday to a nine-month high of 4.986% (from 4.857% a week earlier). Barrons this weekend mentions that China’s central bank may be shifting some of its enormous Treasury holdings from notes to bills. The other explanation, that the market is betting on a second quarter rebound of US GDP, we tackle first under our usual report format below.

THE MATRIX

Real GDP grew only 0.6% in the first quarter, but the consensus is that capital spending will bring 3% growth back, partly on expectations that corporate profits will lift capital spending. However, corporate profits, (up 6.4% in the first quarter) are sharply trending down after five quarters of double-digit growth (see first chart below). On the other hand, consumer demand has been decelerating since the third quarter of 2006 (see next chart), so neither trend supports the pickup in capital spending argument.

With respect to the May jobs number (157k up), it is being questioned not just by perma-bear economists like Roubini, Ritholtz or Kasriel, but by everyone who cared to look deeper, as shown by Justin Lahart´s excellent analysis attached below. Finally, with respect to the strong pick up in manufacturing this quarter, it is obvious this is not in response to new demand from consumers but a natural consequence of companies throttling back production after wiping out 2006´s inventories in the first quarter. As consumer spending may be about to slow significantly (as real estate and credit-card credit taps out), manufacturers may have second thoughts, but for now, stock investors can enjoy the ride, probably until July, when everyone may realize that 3% growth level is not coming back in the second half.

LOCALY GROWN

As shown by Mayela Armas´report below, during the first quarter of this year, we spent $1.2 billion more than we earned during each month. We covered that deficit by issuing new debt and by using up our reserve savings. To be sure, we are not overspending on investment; we are merely financing our monthly public payroll. This partly explains why our reserves are starting to decrease so rapidly, the rest hast to do with the new arrangement whereby the Central Bank never gets to see PDVSA´s dollars before they get spent by the Treasury (also noted in Mayela´s article). In another key economic analysis, Victor Salmeron shows how, not even by boosting imports ($9.1 billion during the first quarter) to a 10-year high have we been able to stop inflation (30.2% in food prices). It looks like if we were able to reach the $40 billion import figure for 2007 (projected from the first quarter), it would have to come from consuming every cent from our liquid Central Bank reserves (some $18 billion –since about $7 billion are gold) and everything we get from PDVSA this year. Yet, even then, our inflation numbers will keep growing together with the incredible growth of our monetary base (60% over the pats 12 months). As pointed out in Salmeron´s article it doesn’t look like our economy is sustainable unless oil prices rocket up miraculously, but soon, because otherwise, it might come to be like the man says: “All this aggravation ain’t satisfactioning me”

PARALLEL UNIVERSE
In our opinion, there are three main factors behind future parallel rates, one is positive and the other two are negative:

Positive
From the minister’s announcement last week, Venezuela is about to issue $500 million in external bonds (Bolivian), together with $500 million in TICC before month’s end. He also announced that at some point during the second quarter, then country will issue another Bono-Sur package with at least $750 million in external bonds (Argentinean and Ecuadorian) plus $750 million in TICC.

Negative
The Central Bank´s Monetary Base stands at Bs. 116.899.747 million (see http://www.bcv.org.ve/cuadros/1/121.asp?id=47), which added to Central Bank CD´s outstanding of Bs. 48.950.964,00 (see http://www.bcv.org.ve/excel/1_3_30.xls?id=132), comprises a total of Bs. 165.850.711 million that can be converted into foreign currency. Simultaneously, Central bank reserves stand at $25.156 million (see http://www.bcv.org.ve/cuadros/2/211.asp?id=28), to which we cannot add FONDEN balances, because they are spent or in the process of being spent and thus cannot sustain currency conversion. Finally, if we divide Bs. 165.850.711 million into $25.156 million, we obtained that the currency’s Implicit FX rate amounts today to Bs. 6.603/$.

Negative
As pointed out above, US real consumer spending would at the heart of the coming recessionary process and if it gets confirmed over the next few weeks or months, it will trigger a stock market sell-off as both always precede recessions. A bursting stock market will bring down with it the prices of all commodities, including oil. If oil falls, the fragile state of our LOCALY GROWN economics, as pointed out above would begin a serious downward cycle.

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